This article is written for those who want to get better at using price to earnings ratios (P/E ratios). To keep it practical, we'll show how Class Limited's (ASX:CL1) P/E ratio could help you assess the value on offer. Class has a P/E ratio of 18.73, based on the last twelve months. In other words, at today's prices, investors are paying A$18.73 for every A$1 in prior year profit.
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Class:
P/E of 18.73 = A$1.44 ÷ A$0.077 (Based on the year to June 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio implies that investors pay a higher price for the earning power of the business. That isn't a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business's prospects, relative to stocks with a lower P/E.
Does Class Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio indicates whether the market has higher or lower expectations of a company. The image below shows that Class has a lower P/E than the average (32) P/E for companies in the software industry.
This suggests that market participants think Class will underperform other companies in its industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.
How Growth Rates Impact P/E Ratios
Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. That means unless the share price increases, the P/E will reduce in a few years. Then, a lower P/E should attract more buyers, pushing the share price up.
Class increased earnings per share by 3.6% last year. And earnings per share have improved by 18% annually, over the last three years.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don't forget that the P/E ratio considers market capitalization. In other words, it does not consider any debt or cash that the company may have on the balance sheet. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
Such expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.
How Does Class's Debt Impact Its P/E Ratio?
With net cash of AU$17m, Class has a very strong balance sheet, which may be important for its business. Having said that, at 10% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Verdict On Class's P/E Ratio
Class has a P/E of 18.7. That's around the same as the average in the AU market, which is 18.2. EPS was up modestly better over the last twelve months. And the net cash position gives the company many options. The average P/E suggests the market isn't overly optimistic, though.
When the market is wrong about a stock, it gives savvy investors an opportunity. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.
Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.